THE Future
of finance
And the theory that underpins it
9 Why and how should we regulate
pay in the financial sector?
Adair Turner
Andrew Haldane
Paul Woolley
Sushil Wadhwani
Charles Goodhart
Andrew Smithers
Andrew Large
John Kay
Martin Wolf
Peter Boone
Simon Johnson
Richard Layard
futureoffinance.org.uk
Copyright © by the Authors. All Rights Reserved. 2010.
Adair Turner and others (2010), The Future of Finance: The LSE Report,
London School of Economics and Political Science.
Cover Design: LSE Design Unit
For further information, contact Harriet Ogborn
Email: [email protected]
Tel: 020 7955 7048
Chapter 9
Why and how should we regulate pay in the
financial sector?
Martin Wolf
This chapter investigates whether there is a case for regulation of financial sector
pay and, if so, how it should be done. It concludes that regulators should not be
concerned with the level of pay. That should be left to tax policy, though there is also a
strong case for investigating the degree of competition in the sector and exploring
remedies if significant monopolies are discovered. But regulators do have a vital interest
in the structure of pay, since shareholders and managers can benefit from gaming the
state's role as insurer of last resort of these highly leveraged and so inherently risky
businesses. Structural reforms, including much higher capital requirements, would help.
But, so long as anything like the present situation prevails, in terms of the structure of the
financial industry, it is vital to prevent management of systemically significant institutions
from benefiting directly from decisions that make failure likely. The answer is to make
decision-makers bear substantial personal liability, in the event of such failures.
“Simply stated, the bright new financial system – for all its talented participants,
for all its rich rewards – failed the test of the market place.” Paul Volcker.1
What, if anything, should be done to regulate the level or structure of remuneration
in the financial services industry? This is one of the most contentious questions to have
arisen out of the global financial crisis. To answer it, we need to address two further
questions. First, what, precisely, is the problem? Second, what might be the solution?
Problems with Financial Sector Remuneration
We live in an era of widening pay inequality in western economies.2 The
extraordinary rewards secured by those in the financial sector have played a substantial
part in this growing inequality. Many would argue that such inequality is itself socially
damaging, whatever the explanation for it: it undermines the sense of social cohesion,
worsens social tensions and undermines equality of opportunity.
1
Address to the Economic Club of New York, April 8 th 2008.
2
See, for example, Ian Dew-Becker and Robert Gordon, "Where did the productivity growth go?",
National Bureau of Economic Research Working Paper 11842, December 2005, www.nber.org; and
Thomas Piketty and Emmanuel Saez, "The evolution of top incomes", National Bureau of Economic
Research working paper 11955, January 2006, www.nber.org.
235
Chapter 9 – Martin Wolf
Yet such objections are multiplied in force when, as is the case for the financial
sector today, these exceptional incomes appear to be the reward not of either merit or
skill, but of rent extraction or ―heads-I-win-tails-you-lose‖ gambling.3 The fact that states
had to rescue the financial sector in 2008, through a combination of aggressive monetary
policy and direct fiscal support, and then nursed it back to health, via regulatory
forbearance and transfusions of cheap money, makes this sense of injustice stronger still.
Contrary to the already notorious statement by Lloyd Blankfein, chairman and chief
executive of Goldman Sachs, that his company does ―God‘s work‖, it is now widely felt
that they are instruments of the devil, instead, making their practitioners wealthy beyond
the dreams of avarice, while laying waste economies, only to benefit from state-led
rescues when threatened with destruction themselves.4
Beyond these broader objections to the growth of inequality, in general, and of
unjust rewards, in particular, concern is expressed over more specific defects to do with
incentives in the financial sector.
The argument here has several steps.
First, financial sector booms and busts create gigantic losses for society, not only
via the direct costs of ―bail-outs‖, but still more via the indirect costs of economic
instability on the economy.
Second, to the extent, that institutions take synchronized risks, they increase the
likelihood and severity of such crises, by creating the conditions in which ultimately
ruinous bets are rewarded, at least for a while.
Third, asymmetric information is pervasive. Thus, strategies with zero expected
excess returns in the long run may look successful in the short run, either as a matter of
luck or because of the nature of the strategy – high probability of small gains with a low
probability of huge losses, for example. Such strategies are extremely common: the ―carry
trade‖ is such a strategy; so was the strategy of buying AAA-rate collateralized debt
obligations, in place of the liabilities of AAA-rated governments. As Raguram Rajan of
Chicago University‘s Booth School of Business has rightly noted: ―true alpha can be
3
On rent extraction, Adair Turner, chairman of the UK‘s Financial Services Authority, notes: ―it
seems likely that some and perhaps much of the structuring and trading activity involved in the complex
version of securitised credit, was not required to deliver credit intermediation efficiently. Instead, it
achieved an economic rent extraction made possible by the opacity of margins, the asymmetry of
information and knowledge between end users of financial services and producers, and the structure of
principal/agent relationships between investors and companies and between companies and individual
employees.‖ See The Turner Review: a regulatory response to the global banking crisis, Financial Services
Authority, March 2009, http://www.fsa.gov.uk/pubs/other/turner_review.pdf, p.49.
4
See ―I‘m doing God‘s Work. Meet Mr Goldman Sachs‖. John Arlidge, November 8 th 2009,
http://www.timesonline.co.uk/tol/news/world/us_and_americas/article6907681.ece .
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Chapter 9 – Martin Wolf
measured only in the long run and with the benefit of hindsight . . . Compensation
structures that reward managers annually for profits, but do not claw these rewards bank
when losses materialize, encourage the creation of fake alpha.‖5
Fourth, shareholders, lack the capacity to monitor risks in complex institutions.
Worse, in highly leveraged limited liability companies, they also lack the interest to
monitor such risks properly, since - as Lucian Bebchuk and Holger Spamann of the
Harvard Law School point out, convincingly - they enjoy the upside, while their
downside is capped at zero.6 Thus, ―leveraged bank shareholders have an incentive to
increase the volatility of bank assets‖, which enhances their potential gains.
Fifth, not only shareholders, but also creditors, lack the interest to price properly the
risks being assumed, since they enjoy a high probability of rescue in the event of failure:
this is the operational core of the idea of ―too big to fail‖.
Sixth, managers also have an incentive to bet the bank to the extent that their
interests are aligned with those of the shareholders. Since share options are a leveraged
play on the gains to shareholders, they make management even more prone to bet the
bank than shareholders. Moreover, the fact that managers sometimes lose does not show
that they were wrong to take such bets. Yet the evidence even suggests that even the
management of failed institutions have been able to cash out substantial winnings before
the collapse.7
Finally, the combination of asymmetric information with the complexity of such
institutions makes it effectively impossible for regulators to monitor the risks being taken.
The problem of remuneration is, therefore, an extreme version of the deep problem
in this sector: the misalignment of incentives between the various decision-makers inside
the system and ultimate risk-bearers, particularly the taxpayers and the wider public. This
is not to say that decision-makers do not also make mistakes induced by over-optimism.
But perverse incentives create what I have called ―rational carelessness‖, which makes
decision-makers underplay risks or even choose to ignore them altogether.8 Thus, it is
impossible to distinguish between the impacts of perverse incentives and cognitive biases.
For this reason, too, it is vital to start our analysis with the challenge of incentives.
5
Raghuram Rajan, ―Bankers‘ pay is deeply flawed, Financial Times, January 9th 2008.
6
See Lucien Bebchuk and Holger Spamann, ―Regulating Bankers' Pay‖, Harvard Law and
Economics Discussion Paper No. 641, May 2009. See also Martin Wolf ―Reform of regulation has to start
by altering incentives‖, Financial Times, June 24th 2010.
7
See Lucian Bebchuk, Alma Cohen and Holger Spamann, ―Bankers had cashed in before the music
stopped‖, Financial Times, December 7th 2009.
8
Martin Wolf, ―The challenge of halting the financial doomsday machine‖, Financial Times, 21st
April 2010.
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Chapter 9 – Martin Wolf
Solutions to Financial Sector Remuneration
So what should, or can, be done about these problems with financial sector
remuneration.
Inequality, rents and competition
As a general proposition, inequality should be dealt with by general taxation, not by
interference in pay levels, least of all interference in pay levels in individual industries. It
may be necessary, however, to limit political lobbying and election spending, to ensure
that this is possible. Experience has also found that direct government control of pay
creates a host of perverse and unintended consequences. But monopoly rent can be
attacked, either by competition policy or, where monopoly rent is an inherent feature of a
market, by turning the industry into a regulated utility. This may well apply to the activity
of market-making, for example.
It would make excellent sense to conduct a rigorous inquiry into the extent of
obstacles to competition in the sector, ideally on a global basis. Where lack of
competition is found, policymakers can then choose between actions that would enhance
competition and moves towards a more regulated industry model. Broadly, it appears
plausible that reforms which increase competition, but also shrink the size of the sector,
increase capital requirements, lower equity returns and reduce excessive risk-taking
should also lower the scale of the rewards available. Indeed, Thomas Philippon of New
York University‘s Stern School of Business and Ariell Resheff of the university of
Virginia have recently estimated that rents accounted for between 30 per cent and 50 per
cent of the wage differential between the financial sector and other industries.9 It would
seem to follow that a successful attack on those rents would also lower these rewards.
Fixing incentives
So far as possible, the problems identified above need to be fixed by changing
incentives – radically so, if necessary. The alternative – effective supervision – is
substantially less plausible and is, in any case, only a second line of defence against
irresponsible risk-taking. So how might this be done?
Broadly speaking, there seem to exist two strategies. The first is to restructure the
financial industry in such a way that the risk-taking parts – sometimes called the ―casino‖
– will never need public bail-outs, in which case one could leave the monitoring of pay
structures to shareholders, themselves monitored by creditors fully aware of the risks they
are running. The second strategy is to assume that the public sector will always be the
9
Thomas Philippon and Ariell Resheff, ―Wages and Human Capital in the U.S. Financial Industry:
1909-2000‖, National Bureau of Economic Research Working Paper 14644, January 2009, www.nber.org.
238
Chapter 9 – Martin Wolf
risk-taker-of-last-resort, and so intervene in the structure, but not the level, of pay, to
ensure that the interests of the public are reflected in those incentives.
On the first of these two approaches, the relevant question is whether restructuring
of this kind would be both feasible and effective. One possibility would be narrow
banking, as recommended by John Kay.10 But the rest of the system would then have to
be credibly free from government insurance, in the sense that all participants would know
that they would live and die by the market. The second, even more radical alternative
would be ―limited purpose banking‖, which is recommended by Laurence Kotlikoff of
Boston University, in which intermediaries would be prevented from taking risk on their
own books, unless they had unlimited liability.11 Instead, any changes in the valuation of
assets would be passed through at once to investors, as mutual funds or unit trust do
today. Financial assets would then be marked to market at all times. Thus, under Mr
Kay‘s proposal, the credit system, as we know it, would be set free, though separated
from deposit-taking, while, in that of professor Kotlikoff, it would effectively disappear.
I am skeptical about the effectiveness of these two structural alternatives. I believe
it is impossible for governments to make a credible pledge to let the credit system as a
whole implode in a crisis. But if this commitment were not credible, there would surely
be excessive risk-taking, which would, in turn, make crises highly probable. Thereupon,
governments would almost certainly prove the truth of the beliefs of those taking the
risks. For this reason, narrow banking alone would be insufficient to make the system
more stable.
Limited purpose banking looks more hopeful, though it is extremely radical: the
financial system, as we know it, would cease to exist: we would no longer have
traditional term transformation. The big question, however, is whether the government
would stand aside when asset prices collapsed. It is used to doing so when equity prices
collapse. But the US authorities did not dare to stand aside when the money market funds
were imperilled by massive withdrawals during the financial crisis of 2009. Instead the
Federal Reserve intervened. True, it is possible that this would not happen if the
vulnerability of the banking system to cascading asset prices were eliminated.
In any case, there is little likelihood of either of these radical structural alternatives
being adopted. This then leaves us with the aim of changing incentives within a system
that continues to enjoy a substantial degree of implicit and explicit insurance by the state.
So how might one change the incentives affecting such institutions?
10
―Narrow Banking: the Reform of Banking Regulation‖, 2009,
http://www.johnkay.com/2009/09/15/narrow-banking/.
11
Laurence J. Kotlikoff, Jimmy Stewart is Dead: Ending the World‟s Ongoing Financial Plague
with Limited Purpose Banking (London: John Wiley & Son, 2010).
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Chapter 9 – Martin Wolf
The first step would be to force financial institutions to become either full
partnerships or, more plausibly, to increase their equity capital and possess large cushions
of contingent capital (perhaps a combined total of as much as 20-30 per cent of assets).12
The advantage of greater equity capital (or near equivalents) is that it would greatly
reduce the likelihood of any need for a government rescue, though it could not eliminate
it. Moreover, with much greater equity, the asymmetry of shareholder incentives would
also be reduced, since the owners of the firm would have far more to lose.
Nevertheless, so long as there were outside shareholders, the latter would still have
only a limited ability to monitor the activities of management and employees. Moreover,
if the social interest in containing risk-taking in financial institutions continued to exist, as
it surely would, the regulator would have a legitimate interest in the structure of
incentives even if shareholders could monitor their employees. This is, indeed, already
widely accepted. So the question is not whether there should be intervention in the
structures of remuneration, but rather what the principles of such reformed structures
should be. Let us list the broad considerations that should apply, before turning to some
details.
First, the regulator, representing the public interest, is interested in the soundness of
the institutions under its supervision, not in maximizing expected returns to shareholders.
At a minimum, therefore, it wants the interests of decision-makers to be aligned with
those financing the balance sheet as a whole, not just with those of the shareholders, who
finance an extremely limited part of the balance sheet.
Second, the regulator wants to ensure that, under no circumstances, can employees
of the firms benefit from risk-taking behaviour that risks the safety of the balance sheet as
a whole – that is to say, makes bankruptcy a likely outcome.
Third, in carrying out this objective, the regulator must make it clear that it is the
responsibility of management and senior staff (namely, those charged with oversight of
risk-management in the firm) to protect its balance sheet, in the public interest.
Fourth, the regulator should also make clear that these decision-makers exercise a
public trust, for whose competent execution they will be held personally liable.
Finally, in ensuring such liability, sufficient time must pass between the making of
decisions and the judgement on whether decision-makers have fulfilled their trust
appropriately.
12
In practice, it would be impossible to raise the capital required by large financial institutions from
a partnership. That was why the limited liability company was invented, in the first place. It seems
particularly important for large financial institutions.
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Chapter 9 – Martin Wolf
Thus, the fundamental ideas are that the decision-makers in the firm exercise a
public trust, which is to protect the balance sheet as a whole, for whose discharge they are
to be held personally liable over a long enough period to make the judgement on their
actions feasible.
How might these ideas be made effective, in practice?
The Squam Lake Report, authored by a distinguished group of American
economists, makes the following recommendation: ―Systemically important financial
institutions should withhold a significant share of each senior manager‘s total annual
compensation for several years. The withheld compensation should not take the form of
stock or stock options. Rather, each holdback should be for a fixed dollar amount and
employees would forfeit their holdback is their firm goes bankrupt or receives
extraordinary assistance‖13 Effectively, this would mean that management would bear
substantial personal liability, in the event of a failure. As the authors rightly note, pay in
deferred stock or in stock options fail to align the interests of the managers with the safety
of the balance sheet as a whole, but only with the portion financed by equity. As they also
note, under such payment schemes, ―managers and stockholders both capture the upside
when things go well, and transfer at least some of the losses to taxpayers when things go
badly. Stock options give managers even more incentive to take risk. Thus, compensation
that is deferred to satisfy this regulatory obligation should be for a fixed monetary
amount.‖14 Then, in the event of failure or government rescue (excluding access to
lender-of-last-resort facilities at the central bank), the sums would be forfeit, unless some
value were left over after all other creditors were made whole. It would be crucial that
such obligations could not be expunged by leaving the firm, but would be in place for a
significant and fixed period of time.
On similar lines, Neil Record, writing in the Financial Times, argues that ―Bankers
who wish to receive a bonus above a threshold (say £50,000, or twice average earnings)
would become personally liable for the amount of the bonus for a period, perhaps 10
years. They would sit between equity holders and other creditors of the bank - and so
would be called upon should any bank find that its equity capital is wiped out by losses.
In practice, this would mean their liability would be triggered by a government or other
(private sector) rescue. If there turned out to be no rescue, then they would be liable to the
liquidator. If there were a rescue, the rescuer would pay over support monies, and then
reclaim them from the limited-liability bankers. The bankers would be released from this
liability over time, but of course with every new bonus payment they would incur a new
liability. By this mechanism, all senior bankers would have a rolling portfolio of
liabilities to the extent of the cash they had taken out of the bank in bonuses. . . . I would
also suggest that bankers' liability should not be an insurable risk; bankers would be
13
The Squam Lake Report: Fixing the Financial System (Princeton and Oxford: Princeton University
Press, 2010), pp.81-82.
14
Ibid., p.82.
241
Chapter 9 – Martin Wolf
prevented by law from insuring their exposure (just as one cannot insure against criminal
penalties).‖15
The details of such proposals are to be worked out. But the nature of the regulatory
requirements seems quite clear.
First, regulators should establish the principle of personal liability of the decisionmakers in the firms.
Second, they should also establish principles on which the relevant key decisionmakers would be identified.
Third, regulators should publish the criteria for determining such personal liability.
Fourth, the liability should be for a substantial portion of total remuneration,
whether paid as bonuses or salary, with the portion rising together with the seniority of
the decision maker at the time he or she received the remuneration. For the chief
executive, that portion should be close to 100 per cent.
Fifth, the liability would be a cash amount, indexed to inflation.
Sixth, the period over which such liability would continue should be substantial –
preferably, at least ten years after receipt of the remuneration. This would be long enough
to establish the viability of many (if not all) strategies. Thus, there would be a rolling
responsibility.
Seventh, stock awards would be permitted, but stock options would be precluded
for such decision-makers. The sale of stock would be prevented if it lowered the net
worth of decision-makers (active or retired) below their liabilities.
Eighth, the liability would be uninsurable.
Ninth, regulators would also have a say in the remuneration structures of the nonkey decision makers in the firm. The principle of claw-back of remuneration, in the event
of failure, would be part of such discussion. In the event of failure, all stock options
should be cancelled, for all employees.
Tenth, senior executives of failed financial firms would be barred from subsequent
employment in the industry for a substantial period of time.
15
242
Neil Record, ―How to make the bankers share the losses‖, Financial Times, January 7th 2010.
Chapter 9 – Martin Wolf
Evidently, such reforms would be far better implemented if they applied across
borders. But, if necessary, countries should go their own way, since they have a vital
national interest in ensuring the safety of the balance sheets of their own firms.
Regulators would then have to agree the principle of remuneration for senior executives
in all systemically significant national financial businesses.
Conclusion
The question of pay is unavoidably fraught. It concerns not just the financial sector,
but the wider economy and, indeed, its political and social stability. It is plausible, in fact,
that the liberalization of the financial sector has had substantial direct and indirect impact
on the widening inequality of private sector pay in many countries over the past three
decades. It is also plausible that remuneration is one factor, among others, that led
financial firms to take a risk-seeking approach to the exploitation of their balance sheets,
with ultimately disastrous results.
On both aspects, therefore, there is a case for policy action. So far as the economy,
as a whole, is concerned, the obvious policy instrument is taxation, since direct controls
on pay are likely to have unintended adverse consequences. But, in the case of finance, it
also makes sense to undertake a rigorous assessment of competition. Should there be
severe competition issues, policy-makers should consider remedies: either competition
should be enhanced or regulation be introduced, as in any other monopolistic industry.
Market-making is an obvious area for such treatment.
Beyond this, the structure – rather than the level – of pay in the financial sector
must be regarded as a matter of public interest, since taxpayers are the risk-takers of last
resort. The fundamental problem is that, in the case of the financial industry, with its
highly leveraged balance sheets, limited liability creates perverse incentives for both
shareholders and management. These are not fully offset by the creditors, partly because
the latter rightly believe that they enjoy the benefits of explicit and implicit taxpayer
insurance. These perverse incentives encourage rational carelessness, with intermittently
catastrophic results.
So what is to be done? The regulators have a duty to correct the perverse incentives
at work. Higher capital requirements would help. But it would not be enough. Massive
structural change in the financial system might also help. But it is unlikely to occur. Thus,
it is also important to motivate management to protect the balance sheet as a whole and
not just identify their interests with those of shareholders, since maximization of expected
shareholder returns can leave huge tail risks with taxpayers.
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Chapter 9 – Martin Wolf
For this reason, regulators should insist in a change in the structure of incentives, to
discourage executives with responsibility for risk-management from ―gaming the state‖.
Since outside supervision is likely to fail, the best way to achieve this result is to make
management liable in the event of bankruptcy or state rescue. This can be achieved by
forcing a substantial part of remuneration to be held back for an extended period,
probably 10 years, and then lost, in the event of failure. In this case, the management of
failed institutions would lose much of their accumulated wealth. In addition, stock
options, with their perverse, one-sided incentives should be eliminated for all employees
of systemically significant financial institutions and all variable pay should be subject to
claw-back in the light of subsequent performance.
Aligning the interests of those who work in the financial sector with those of
creditors, including the creditor of last resort – the state – would not solve every problem
in the industry. But it is the best way to realign incentives. The crucial step is to abandon
the idea that shareholder interests alone count. They do not. In the case of financial
institutions, there is a wider public interest in actions that minimize the chances of
bankruptcy. Making decision-makers substantially liable in the event of failure of the
business under their control is also a vital part of the solution.
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Chapter 9 – Martin Wolf
References
Arlidge, J. (2009) ―I‘m doing God‘s Work. Meet
Mr
Goldman
Sachs‖,November
8th
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Philippon, T. and A. Resheff, (2009) ―Wages and
Human Capital in the U.S. Financial Industry:
1909-2000‖, National Bureau of Economic
Research Working Paper 14644, January,
www.nber.org
Bebchuk, L., A. Cohen and H. Spamann, (2009)
―Bankers had cashed in before the music
stopped‖, Financial Times, December 7th.
Rajan, R. (2008) ―Bankers‘ pay is deeply flawed,
Financial Times, January 9th.
Bebchuk, L. and H. Spamann, (2009)
―Regulating Bankers' Pay‖, Harvard Law and
Economics Discussion Paper No. 641, May.
Record, N. (2010), ―How to make the bankers
share the losses‖, Financial Times, January
7th.
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did the productivity growth go?", National
Bureau of Economic Research Working
Paper 11842, December, www.nber.org
The Turner Review: a regulatory response to the
global banking crisis, Financial Services
Authority,
March
2009,
http://www.fsa.gov.uk/pubs/other/turner_revi
ew.pdf
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Kay, J. (2009) ―Narrow Banking: the Reform of
Banking Regulation‖,
http://www.johnkay.com/2009/09/15/narrowbanking .
Kotlikoff, L.J, (2010), Jimmy Stewart is Dead:
Ending the World‟s Ongoing Financial
Plague with Limited Purpose Banking,
London: John Wiley & Son
Wolf, M. (2010) ―Reform of regulation has to
start by altering incentives‖, Financial Times,
June 24th.
Wolf, M. (2010) ―The challenge of halting the
financial doomsday machine‖, Financial
Times, 21st April.
Volcker, P. (2008), Address to the Economic
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